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The (Sometimes Shady) Business of Making Money

Banks are in a highly competitive industry so they constantly look for advantages -- sometimes illegal ones.

Tom Hayes may not be a household name yet, but with the recent LIBOR conviction on his record he received temporary residency in a state penitentiary.

And as the LIBOR scandal is rocking the banking space, Bank of America(NYSE:BAC) is moving up in terms of investor enticement. With one lawsuit under its belt and millions of legal fees crushed, it's only a matter of time before the stock catches up with this bank's long overdue success. Will giving the CEO more power as head chairman increase their popularity even further?

A full transcript follows the video.

Gaby Lapera: Bank shenanigans; this is Industry Focus.

Hello, everyone. Welcome to Industry Focus, financials edition. My name is Gaby Lapera. Joining us this week is John Maxfield on the phone. We've got a great show lined up this week on Bank of America, along with some discussions on the ethics of how banks make money.

Let's start with Bank of America. I understand they've just increase the debt rating.

John Maxfield: That's right. During the last quarter in Bank of America's most recently filed 10-Q, we found out that all three debt rating agencies increased its debt rating between May and July.

Lapera: That's crazy! Has anyone else really talked about this yet?

Maxfield: I have not been able to find any type of news article about this, which is really shocking to me because a debt rating for a bank is so important. The only way this information could have been found was to actually look at the press releases from the debt rating agencies themselves.

Often times those press releases are behind a "paywall", or a "membership wall" where you have to sign in and then move to that next level.

Lapera: Why is it so important that their debt rating has been increased?

Maxfield: It matters for banks because if you think about what a bank is, it's capital. In Bank of America's case you've got $200+ billion in capital, and then it goes out and borrows a bunch of money. Then it lends the money that it borrows out to other borrowers to buy securities. What really matters is that you can borrow money inexpensively and then lend it out at a much higher interest rate.

Your debt rating matters because it impacts the interest rate at which Bank of America can borrow on the bottom line. If they have a high debt rating then its cost of funds is much lower. If it has a lower debt rating -- as it has since the financial crisis -- then its cost of funds is higher and it makes less money.

Lapera: That makes a lot of sense. Bank of America has also been in the news this week for another issue. It's a little bit of a kerfuffle because it looks like Bank of America changed its bylaws about consulting any investors in order to make the current CEO, Brian Moynihan, also a chairman of the board.

For context, Bank of America investors voted to separate the two positions in early 2009 following the beginning of the recession. They were worried then, as they are now, about having too much decision making power concentrated in one individual. Bank of America decided to do this anyway. What do you think about that?

Maxfield: It's a good question. You would see this reflected in the corporate structure of most publicly traded companies, but as a general rule you don't want too many cooks in the kitchen. You hire a CEO because you trust him to lead that company. If you don't trust a CEO to lead the company without oversight then you've probably hired the wrong CEO.

As a general rule, the question is: is it a bad thing to not have oversight? I don't think it is because it just streamlines decision making in the first place.

Lapera: Do other corporations have this CEO/Chairman combo structure?

Maxfield: I would say this is kind of the consensus structure with most publicly traded companies. If you look at the biggest banks in particular -- Wells Fargo (NYSE:WFC), J.P. Morgan Chase (NYSE:JPM), Goldman Sachs(NYSE:GS) -- they're CEOs are also their chairmen. It's only Bank of America and Citigroup(NYSE:C) where you had that separation for a while.

Of course, Bank of America has come back into place. The reason you had that separation at Citigroup and Bank of America was because you had their CEOs, their pre-crisis CEOs that were either fired, or left on their own accord. Then you had a new CEO step into the position. Generally, even like at Wells Fargo where you had John Stumps as the CEO on the eve of the crisis, their prior CEO stayed on as chairman for roughly a year.

It's not unusual when you have a change over at the top to then have those roles separated, at least temporarily.

Lapera: From another perspective, given all of Bank of America's trouble since Moynihan took over; is he really in an effective position to be a chairman?

Maxfield: That's the question of the day. I would say if you look at how Brian Moynihan has led the bank since the financial crisis, it's really difficult to compare his performance to other CEOs because what Bank of America went through was so unique. They had upwards of $100 billion of legal claims over the last eight years.

It's so unique that it's really hard to gage it. I would say, when you consider where Bank of America is today, particularly after the most recent quarter in which they had a really fantastic performance; Brian Moynihan is a CEO who delivered them from the beginning of 2010 when those legal bills really started rolling in, until today where there's that recovery.

From that perspective I would say that Brian Moynihan has proved his medal at that position. If there's anyone who knows how to run Bank of America in its current form, certainly I would say that Brian Moynihan is the top person.

Lapera: How did he get into this combo position? It's clearly something that investors didn't want and they're going to vote on the issue for the first time in the coming week. How did the board end up the way it is?

Maxfield: Let me clarify one thing: we don't know for sure if this is a structure that Bank of America shareholders want right now. We know that they didn't want it when the facts and Bank of America's performance were much worse. Now we see the fruits of Moynihan's labors.

The vote that's coming up may look very different in that regard, but to your question about how Brian Moynihan got into this position, when you consider the fact that Bank of America's performance was so poor in the aftermath of the crisis; this is a story I love because, when you look at Bank of America, it's actually a bank called "nation's bank".

It's a North Carolina bank. If you look at nation's bank and you trace it all the way back to the 1950s which is when it started on its growth spurt that then catapulted it into the second largest bank in the United States; it's been controlled by a very tight lineage of southern executives.

You have Brian Moynihan step in through the FleetBoston Financial merger and merged with Bank of America in 2003. He's filling up the executive suite with Boston executives. At the time he was elected both CEO and then chairman, they had a large contingent of FleetBoston Financial executives that were on the Bank of America board. To a certain extent you almost have a Boston based coo, if you will, at the top of the nation's second largest bank.

Lapera: That is really interesting. Speaking of shadowy bank dealings; I would really like to talk about the recent LIBOR conviction. LIBOR stands for the London Inter-Bank Offered Rate and it's the rate at which banks can borrow money from each other. It's calculated by Thomson-Reuters and based on a group of banks in London.

They figure this out by asking the banks how much their cost to funds are. Recently, Tom Hayes was convicted of manipulating this rate. What does this mean for banks? What would they have to gain by manipulating the LIBOR rate?

Maxfield: In terms of manipulating the LIBOR rate, you're basically manipulating the markets. These are traders, so if you're a trader and you can dictate the price of a security, or an interest rate, and interest rates set security prices then you can trade ahead of that.

Let's say I can dictate that the Bank of America shares are going to go up to $20 tomorrow. Then I can just go buy a bunch of call options and make a ton of money. That's the reason that they manipulate it; to make a lot of money.

Lapera: Has this type of manipulation happened before?

Maxfield: This is a pretty common thing. I would say it's a common thing since the beginning of publicly traded markets in which securities are publicly traded. Over the most recent history, this has come more into focus because regulators have been looking at banks so closely.

Just to give you a list off the top of my head, you have the LIBOR, you have the Forex Exchange Settlements where the banks were manipulating foreign currency exchange rates, and then trading in advance of that. Goldman Sachs and J.P. Morgan Chase have both been implicated in fixing commodity markets. Goldman Sachs in the aluminum market, and J.P. Morgan Chase in the energy markets.

Then a whole bunch of the biggest banks were sanctioned for manipulating the market of municipal bonds. It's a pretty common thing when you're talking about trading operations at banks.

Lapera: Why do you think banks end up doing stuff like this?

Maxfield: First of all let me say that I think it probably drives the CEOs nuts. I've read a lot about Jamie Dimon and I think he's an incredible banker. If you look at his history as he came up with Sandy Weill at Citigroup, and then Chance went over the Bank One and then Bank One was purchased by J.P. Morgan Chase; at all of these different stages along the way Jamie Dimon has had to deal with huge losses by "rogue traders".

I can tell you that the CEOs really dislike it. The reason this type of thing can happen at banks is because if you don't have a tight risk control on each of your traders, with the type of derivatives that you can buy nowadays that are so heavily leveraged; even a single individual can expose a lot of a bank's capital to potential losses.

My favorite story about this is when Barings Brothers Bank -- which goes back centuries and was competing against the Rothschild's since the beginning of modern European banking -- and it was brought down in the 1990s from a single rogue trader.

Lapera: That's crazy. One of the things that really fascinated me about this and was probably similar to what happened before is, this is one individual -- according to the lawsuit, and we can always get into whether or not he really was on his own and if management actually knew what was going on -- but this is one individual.

You read that he's a math genius, and a lot of the articles don't really get into specifics about exactly how he manipulated the rate. Further reading shows that he just found the people in charge of helping set the rates and he bullied them into doing what he wanted. That's insane. It really does come down to people doing people things, trying to get ahead.

Maxfield: That's exactly right. It's so tempting to be sanctimonious when you look at someone else's behaviors, but you're talking about a gentleman who probably has a family -- and I'm just speculating -- and he's put into a position where he can make highly leverage, potentially profitable bets with other people's money, but then he will reap the rewards. The rewards being a significant share of the monetary rewards through his bonus.

On the other side of that, if he loses a bunch of the shareholder's money he may be fired, but it's not like it's going to necessarily be coming out of his own bank account. It turns out he's in a lot of legal problems, but that's a rarity among rogue traders. Typically, they're able to get by, get fired, and move on down the road.

You have this asymmetry of risk that I believe is underlying that and when you have a guy with a family, trying to get as rich as he can, setup dynastic wealth for his family for generations; that's an understandable reason that you would do this. That's not to say that it's excusable, but it is to say that a lot more of us would act in a similar way under that system of incentives.

Lapera: For the listeners out there who haven't been following this case as closely, I will say Tom Hayes did get sentenced to 14 years in prison as a result of his manipulation tactics. He didn't escape unscathed.

Maxfield: No, he didn't. That's a good point. What you have to understand is that is the rare exception to the rule. The general rule is that these traders can make these enormous bets, get rich, or either lose money and get fired and go on to another firm. There's a relatively limited downside to the individual trader.

Lapera: Right. In some cases, part of the reason UBS is being accused of "under the table" sanctioning Hayes is because it did help them get ahead in the derivatives market. Overall, I think there's a theme to everything we've talked about today. These banks are in a high risk, high competition industry and they're looking for any kind of advantage they can possibly get.

Maxfield: I would say that's a good takeaway. Let me touch on one thing, as we've talked about Bank of America quite a bit. I just want to drive home this point to investors, because Bank of America is the most heavily traded stock on the stock market in the United States. The fact that Bank of America's debt rating improved is a very big, very important thing for this bank.

When you couple it up with the fact that they made quite a bit of money in the last quarter, and the fact that their legal liabilities were slashed by $7.6 billion because of a case, and that new claims were literally throttled from what was torrent before, down to a trickle; when you put all these things together and consider the fact that no one is out there talking about how significant the drop in legal claims was, and how significant this debt rating improvement is, it could lead one to believe that the public markets aren't pricing some of these really positive developments into Bank of America stock right now.

You can see this by the fact that despite all of these things, Bank of America's stock still trades for double digit discount to book value. When you add one more piece on top of that -- I've looked at previous bank crisis in the past and one of the things we see is, when banks come out of these it happens quickly, and it happens very significantly.

Last time Bank of America really got into one of these serious things was in the 1980s. After three successive years of losses it came out earning a ton of money. It's a good thing for investors to keep in mind. In my opinion, it certainly seems like these positive developments are not being priced into its stock right now.

Lapera: Okay. Lots of interesting things to think about. Want to remind our listeners as always people on the program may have interests in the stocks they talk about, and The Motley Fool may have formal recommendations for or against. So, don't buy or sell stocks based solely on what you hear. Thank you very much for joining us, and I hope you guys have a great day.